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[Updated: 3:45 pm] Omeros, the Seattle-based biotech company, went public back in the fall of 2009 partly on optimism that it had found a novel way to help people recover from knee surgery. Today, the company is reporting that the program was essentially a bust. Omeros stock fell 40 percent on the news in after-hours trading.

Omeros (NASDAQ: OMER) said today that its most advanced program in clinical trials, a combination of generic drugs designed to reduce pain and swelling in patients undergoing arthroscopic knee surgery, has failed. There was nothing to sugarcoat here—the drug, OMS103HP, failed to meet its goals in the third and final stage of clinical trials. Omeros blamed confounding factors in the studies, which means that if patients improved, it could have been caused by some other reason than the Omeros drug. And the treatment failed in more than one study. The Phase III program involved three clinical trials, composed of 1,040 patients, according to Omeros’ most recent annual report.

“We are obviously disappointed and surprised by the outcome,” Omeros CEO Greg Demopulos said in a statement.

The Omeros treatment is a combination of three generic pharmaceuticals—the anti-inflammatory compound known as ketoprofen, the pain reliever amitriptyline, and a blood vessel constrictor known as oxymetazoline. By adding that mix to a standard surgical irrigation solution, Omeros hoped it would help people suffer less pain, and ease the recovery from arthroscopic knee surgery. The market potential for something here is quite big—about 2. 6 million arthroscopic knee surgeries are performed each year in the U.S., and the numbers are only thought to go up as Baby Boomers get older.

Omeros is still combing through the data, and didn’t say in today’s statement what it plans to do next. The company said the latest findings do not appear to undermine use of the drug for a type of knee surgery known as meniscectomy.

Fortunately for Omeros, it hasn’t bet the entire company on OMS103HP. The company reported on some positive findings last week from a mid-stage study of patients on a drug for cataract surgery. And Omeros raised $25 million last year from Paul Allen’s Vulcan Capital and the state’s Life Sciences Discovery Fund to support a discovery program that hopes to uncloak a number of promising new drug targets known as G-protein coupled receptors.

Shares of Omeros dropped 40 percent in after-hours trading, down to $4.81 at 6 pm Eastern, following remarks by Demopulos on a conference call.

[Updated with comments from Omeros conference call.] While Omeros is still analyzing the data to determine what went wrong, Demopulos did note that there was a lot of variability in how the study was conducted over a period of years. It was designed so that a physical therapist performed a post-operative functional assessment of the patient. The problem in a large study, with multiple centers, is that there is bound to be a lot of variation in how those individuals perform the functional assessment, Demopulos said. Omeros tried to account for this with consistent training of clinical sites and follow up, Demopulos said.

The company’s cash position is now bound to attract more scrutiny. Omeros said it entered the year with $42 million in cash and investments, after burning through about $18 million of its cash balance in 2010. Demopulos assured analysts that the company is comfortable it has more than 12 months of cash left. Yet that comment was made based on some new information Omeros disclosed today. Omeros said in a separate regulatory filing today that it agreed to borrow $10 million from Oxford Finance in a transaction dated March 25th, and Demopulos told analysts the state Life Sciences Discovery Fund still owes Omeros a $5 million payment.

Demopulos didn’t try to hide the depth of his disappointment in the clinical result, but in his closing remarks, he urged people not to give up on the company.

“This is part of the business we are all in. At Omeros, we have an outstanding group of people, and we are building a company around a unique and valuable set of assets. While there are no guarantees, I don’t expect to make a habit of delivering this kind of news.”